With signs that the recession is bottoming out, European policymakers now need to focus on securing a durable recovery and addressing the threats to potential growth from the financial crisis and the continent’s traditional structural rigidities. In the near term, further action to restore normal functioning of the financial system remains crucial, while policymakers will need to move carefully both to sustain the upswing and to prepare for exit from the extraordinary interventions in a coordinated fashion. And many emerging economies will need to adapt to lower capital inflows, address debt overhangs, and institute structural change.
Few doubt that the crisis will have a negative effect on economic growth in Europe beyond the short term, but considerable uncertainty prevails over its magnitude. For countries where the financial sector contributed heavily to economic growth before the crisis, a continuation of historical levels of trend growth may be difficult, while economies relying on strong capital inflows could suffer a dent in their long-term growth or convergence process. In the medium term, the time-varying component of potential growth could be negative in almost all advanced European countries. Emerging economies could see lower medium-term growth because of dwindling capital inflows and higher government debt levels. Hence, intensified structural reforms are crucial to alleviate some of these adverse effects on potential growth and, in many emerging economies, need to be complemented by a further strengthening of policy frameworks.
Potential output is falling in the aftermath of the crisis, although the extent of the drop is uncertain. Monetary policymakers should take into account the reduction in potential output and the surrounding uncertainty by clearly communicating their views on potential output and their intent to adjust as new information becomes available. This approach will help anchor expectations for inflation and limit the costs of policy mistakes. Fiscal policy has to absorb the double blow dealt by the crisis to potential growth and debt levels. Even under very benign assumptions about the path of potential output, the required fiscal adjustment will be large, suggesting that policymakers should err on the side of caution and start the necessary consolidation as soon as the state of the cycle allows.
Emerging Europe is likely to face higher risk premiums and a more volatile environment in the aftermath of the financial crisis. While the global crisis might be receding, investors are paying increased attention to domestic factors and policies, creating significant cross-country differences in sovereign spreads. Higher and more volatile spreads increase the variability of inflation and output over the cycle, with further deleterious effects on investment, growth, and prospects for convergence. Restoring the normal functioning of the financial system where needed, and strengthening financial stability and fiscal sustainability frameworks will go a long way toward addressing these concerns. Such policies could yield a “double dividend” by lowering the volatility of the business cycle and improving prospects for long-term growth.